Chapter 10 Special Pricing Policies Outline • • • • • • • Cartel arrangements Price leadership Revenue maximization Price discrimination Nonmarginal pricing Multiproduct pricing Transfer pricing Copyright ©2014 Pearson Education, Inc All rights reserved 10-2 Learning Objectives • • • • Analyze cartel pricing Illustrate price leadership Understand price discrimination, and its effects Distinguish between marginal pricing and “costplus” pricing • Discuss the various types of multiproduct pricing • Explain the meaning of “transfer pricing,” and explain how a company should price products that pass from one operating division to another Copyright ©2014 Pearson Education, Inc All rights reserved 10-3 Cartel Arrangements • A cartel is an arrangement where firms in an industry cooperate and act together as if they were a monopoly • Cartel arrangements may be informal or formal • Illegal in the U.S.: Sherman Antitrust Act, 1890 Examples: OPEC, IATA Copyright â2014 Pearson Education, Inc All rights reserved 10-4 Cartel Arrangements • Conditions that influence the formation of cartels – – – – most common in oligopoly market structures small number of large firms in the industry geographical proximity of the firms homogeneous products that not allow differentiation – stage of the business cycle – difficult entry into industry – uniform cost conditions, usually defined by product homogeneity Copyright ©2014 Pearson Education, Inc All rights reserved 10-5 Cartel Arrangements • Pricing and Profit Decisions – in order to maximize profits, the cartel as a whole should behave as a ‘monopolist’ – the cartel determines the output which equates MR = MC of the cartel as a whole – the MC of the cartel as a whole is the horizontal summation of the members’ marginal cost curves – price is set in the normal monopoly way, by determining quantity demanded where MC=MR and deriving P from the demand curve at that Q Copyright ©2014 Pearson Education, Inc All rights reserved 10-6 Cartel Arrangements MCT is the horizontal sum of MCI and MCII QT is found at the intersection of MRT and MCT  price is found from the demand curve at QT … this is the price that maximizes total industry profits Copyright ©2014 Pearson Education, Inc All rights reserved 10-7 Cartel Arrangements To determine how much each firm should produce, draw a horizontal line back from the MRT/MCT intersection Where this line intersects each individual firm’s MC determines that firm’s output, QI and QII Note that the firms may produce different outputs Key point: the MC of the last unit produced is equated across both firms Copyright ©2014 Pearson Education, Inc All rights reserved 10-8 Cartel Arrangements Profits for each firm are shown as rectangles in blue Firms may earn different levels of profit, though combined profits are maximized Copyright ©2014 Pearson Education, Inc All rights reserved 10-9 Cartel Arrangements • There may be an incentive for firms to cheat on agreements, thus cartels are unstable • There are additional costs facing a cartel – – – – Formation costs Monitoring costs Enforcement costs Potential cost of punishment by authorities Copyright ©2014 Pearson Education, Inc All rights reserved 10-10 Non-marginal Pricing Incremental pricing (and costing) analysis: deals with changes in total revenue and total cost resulting from a decision to change prices or product – incremental, similar to marginal analysis – only revenues and costs that will change due to the decision are considered – examples of product change: new product, discontinue old product, improve a product, capital equipment Copyright ©2014 Pearson Education, Inc All rights reserved 10-29 Multiproduct Pricing When the firm produces two or more products •Case Fixed proportions: products are complements in terms of demand, an increase in the quantity sold of one will bring about an increase in the quantity sold of the other •Case Variable proportions: products are substitutes in terms of demand, an increase in the quantity sold of one will bring about a decrease in the quantity sold of the other Copyright ©2014 Pearson Education, Inc All rights reserved 10-30 Multiproduct Pricing When the firm produces two or more products • Case 3: products are joined in production, – products produced from one set of inputs • Case 4: products compete for resources, using resources to produce one product takes those resources away from producing other products Copyright ©2014 Pearson Education, Inc All rights reserved 10-31 Transfer Pricing Internal pricing: as the product moves through these divisions on the way to the consumer it is ‘sold’ or transferred from one division to another at a ‘transfer price’ Rationale: •firm subdivided into divisions, each may be charged with a profit objective Copyright ©2014 Pearson Education, Inc All rights reserved 10-32 Transfer Pricing • Without any coordination, the final price of the product to consumers may not maximize profits for the firm as a whole Copyright ©2014 Pearson Education, Inc All rights reserved 10-33 Transfer Pricing • The design of the transfer pricing mechanism must be geared toward maximizing total company profit; therefore, the final pricing policy may be dictated centrally from the top of the corporation Copyright ©2014 Pearson Education, Inc All rights reserved 10-34 Transfer Pricing Case A: no external markets – no division can buy from or sell to an external market – the selling division will produce exactly the number of components that will be used by the purchasing division – one demand curve and two MC curves – MC curves are summed vertically – set production where MR = Total MC Copyright ©2014 Pearson Education, Inc All rights reserved 10-35 Transfer Pricing Case B: external markets – divisions have the opportunity to buy or sell in outside competitive markets – if selling division prices above the external market price, the buying division will buy from outside – if selling division cannot produce enough to satisfy buying division demand, the buying division will buy additional units from the external market Copyright ©2014 Pearson Education, Inc All rights reserved 10-36 Other Pricing Practices • Price skimming – the first firm to introduce a product may have a temporary monopoly and may be able to charge high prices and obtain high profits until competition enters • Penetration pricing – selling at a low price in order to obtain market share Copyright ©2014 Pearson Education, Inc All rights reserved 10-37 Other Pricing Practices • Limit pricing – A monopolist will set price below MR = MC to prevent potential customers from entering the market • Predatory pricing – Setting price below marginal cost to drive competitors out of the market Copyright ©2014 Pearson Education, Inc All rights reserved 10-38 Other Pricing Practices • Prestige pricing – demand for a product may be higher at a higher price because of the prestige that ownership bestows on the owner • Psychological pricing – demand for a product may be quite inelastic over a certain range but will become rather elastic at one specific higher or lower price Copyright ©2014 Pearson Education, Inc All rights reserved 10-39 Global Application • Example: decline of European cartels • • • • carton-board vitamin copper pipe elevator operators Copyright ©2014 Pearson Education, Inc All rights reserved 10-40 Summary • Cartels are formed to avoid market competition and maximize profits However, as history shows, such arrangements are not always stable • Price leadership exists when one company establishes a price and others follow Two types of price leadership were discussed: barometric and dominant • Baumol’s model describes the actions of a company whose objective is to maximize revenue Copyright ©2014 Pearson Education, Inc All rights reserved 10-41 Summary • Price discrimination (or differential pricing) exists when a product is sold in different markets at different prices Third-degree price discrimination is the most common • A firm can increase its profits over what they would be if a uniform price were charged by price discrimination • Cost-plus pricing appears to be a very common method but often ignores marginal principles and demand curve effects Copyright ©2014 Pearson Education, Inc All rights reserved 10-42 Summary • Multiproduct pricing was examined, because most firms and plants produce more than one product at the same time • Multiple products produced by one firm can be complements or substitutes, both on the demand side and the supply side • Transfer pricing is used to determine the price of a product that progresses through several stages of production within a firm Copyright ©2014 Pearson Education, Inc All rights reserved 10-43 ... produce by equating the marginal revenue and marginal cost in the market as a whole: QT If the firm were forced to charge a uniform price, it would find the price by examining the aggregate demand... normal monopoly way, by determining quantity demanded where MC=MR and deriving P from the demand curve at that Q Copyright ©2014 Pearson Education, Inc All rights reserved 10- 6 Cartel Arrangements... ‘residual demand curve’ DD • The dominant firm sells A units and the rest of the demand (QT – A) is supplied by the follower firms Copyright ©2014 Pearson Education, Inc All rights reserved 10- 15 Revenue